College costs can complicate teen's savings plan

Gail MarksJarvisTribune staff reporter

Q: My wife and I are thinking about opening a Roth IRA [individual retirement account] for our 16-year-old son. I've paid attention, as you have suggested that small savings early in life can turn into million-dollar nest eggs. Is there any reason why we shouldn't open a Roth IRA for our son? -- M. H., Allentown, Pa.

A: If you were considering giving your son a Roth IRA as a college graduation gift, it would be a no-brainer. I'd applaud your decision--maybe even nominate you for a "Parent of the Year" award, for providing your son a tremendous head start on his financial future. For a 16-year-old, the question is more complicated. That's because college costs lie ahead, and your son's investments could make college more expensive for your family than they need to be.

That's unfortunate, because a Roth IRA truly could make a remarkable impact on a 16-year-old's future.

Just remember: You cannot put more money into a Roth than your son earns. But if you were to open a Roth IRA and put $4,000 in a mutual fund that invests in the total stock market, your son would likely amass more than $500,000 by retirement if the stock market grows at the 10 percent annual average it has historically. That sum is based on a one-time $4,000 investment into a total stock market index fund, and adding nothing more over the years besides the money that your son earns on the original $4,000 investment.

If you invested $3,000 for your son this year, and did the same thing again the next couple of years, he could amass about $1.3 million, even if he never added a cent of new money beyond his earnings in the stock market mutual fund.

When I have urged parents to do this in the past some have objected -- saying children need to save on their own, rather than depend on a kindly parent or grandparent.

Often, however, early investments encourage -- rather than discourage -- saving. About half of people in their 20s skip contributing to 401(k) retirement savings plans at work because they don't understand the power of compounding to grow small savings. But when people do start investing early and see paltry savings grow dramatically, they often become motivated to dig into their paycheck for a little extra to invest.

Those small amounts deliver huge benefits, especially when people start investing in their 20s. Investing just $5 a week can ultimately deliver over $200,000.

All of that potential aside, opening a Roth IRA for a 16-year-old, "may not be a good idea," says Kalman Chany, author of "Paying for College Without Going Broke."

That's because some colleges will reduce financial aid for students who have any savings, even if they are in accounts like IRAs, which are designed for retirement savings.

If your son will attend a public college you probably don't need to worry about this. Such colleges compute financial aid using a federal formula, and a form called the Free Application for Federal Student Aid, or FAFSA.

The formula allows low-income and moderate-income families to receive aid even if members have retirement savings. But each private college has its own rules. Many ask families to fill out a form called the PROFILE, and in it they must disclose any IRA or 401(k) savings a student has acquired, Chany said.

Some colleges may ignore the accounts. Others will, in effect, tell parents to use the student's Roth IRA money to pay for college. That could mean grants -- or free money -- could be cut, and parents will have to dig deeper into their pockets to pay for college than they would otherwise.

With tuition at many private colleges running more than $42,000 a year -- or about $168,000 for four years -- most families need all the financial aid they can get. So it's not worth taking a chance with a Roth IRA for a child about to attend college.

That's unless your income is so high that financial aid seems out of the question. Chany said if your income is over $250,000 you probably won't qualify for aid. Once your income crosses the $150,000 threshold your chances of obtaining financial aid start to diminish. Although circumstances vary, at public colleges it is difficult to obtain financial aid if your income is around $50,000 or higher.

You can run a financial aid calculation at www.finaid.org to see if you are likely to get grants. Try www.finaid.org/calculators/finaidestimate.phtml and use the "institutional methodology" for private colleges.

If you decide to open a Roth IRA for your son keep in mind that you can't deposit any more in it than he earned working or operating a business during the tax year, and the maximum annual contribution is $4,000.

In addition, don't just hand over the gift without explanation. You want to make him aware of his power to grow money, and provide an incentive to keep socking away as much as he possibly can.

Explain that an 18-year-old can invest about $20 a week and end up with about $1 million. Yet, a 35-year-old needs to invest about $100 a week to get to the same point by retirement and a 45-year-old would need $300 a week. The calculator at www.moneychimp.com, will illustrate the power of compounding. Also, help him realize that $1 million today won't equal $1 million tomorrow because inflation erodes the value of money.

A calculator at www.choosetosave.org shows the impact of inflation on money, plus the benefit of shielding savings from taxes in an IRA.

One of the best ways I have seen parents help children maximize the use of Roth IRAs is to make a deal with them. Tell your son that you are providing an initial amount because you know he will need a lot of money for his future. Maybe you provide $500; maybe up to $4,000. But get him to promise to help himself, too.

Ask him to sign up to make small contributions automatically each month -- maybe just $5. Show him how to watch his money increase, and decrease, in his account over time as the stock market fluctuates. Make him aware that the market will go through cycles, but if he leaves his money invested for many years it's likely to average an 8 percent to 10 percent return a year.

Gail MarksJarvis is a Your Money columnist and the author of "Saving for Retirement Without Living Like a Pauper or Winning the Lottery." Contact her at gmarksjarvis@tribune.com.